The following points highlight the top ten techniques of performance evaluation. The techniques are: 1. Budgetary Control and Reporting 2. Balanced Scorecard 3. Variance Analysis 4. Contribution Margin 5. Return on Capital Employed (ROCE) 6. Residual Income (RI) 7. Value Added 8. Bench Marking 9. Ratio Analysis 10. Non-Financial Quality Performance Measures.
Evaluation Performance: Technique # 1. Budgetary Control and Reporting:
Preparation of the budget is the first step in the budgetary control system. Implementation of budgets is the second phase which needs continuous reporting of budget performance at short intervals. Preparation of budgets alone will not achieve much unless a comparison is made regularly between the actual performance and the budgeted performance.
Thus proper reporting is an essential element in budgetary control. The daily/weekly/monthly reports depending on the nature of operations involved in the results of various functions are regularly submitted to the management and follow up action has to be taken immediately.
In this respect, budget reports showing the following information will prove useful:
(a) Budgeted level of activity and budgeted cost of the same.
(b) Budgeted cost of actual level of activities.
(c) Actual cost of actual activity.
(d) Variance between budgeted figures and actual figures.
(e) Reasons of variance.
The importance of reporting lies in the fact that it brings into light the areas which need management attention. It will help in taking timely action for taking corrective measures. Thus, reporting will disclose the persons who are responsible for the variance.
It is also possible that variance may not be due to employees but may be due to external factors (i.e., change in wage rates, prices of materials, slack market etc.) which are uncontrollable for which no operative or executive can be held responsible.
Budget reports to top management should explain the difference between the profit in the profit plan stating the factors involved in quantitative and financial terms show the flow of funds and projections in this regard and provide feedback about the achievement of goals and objective of the firm.
Various budget reports such as sales budget report, production budget report, purchases budget report, labour budget report, expenses budget report, cash budget report, capital expenditure budget report, research and development budget report etc., can be prepared to highlight the activities of various functional budgets.
A specimen form of sales budget report is given below:
Evaluation Performance: Technique # 2. Balanced Scorecard:
This is an approach that links both the financial and non-financial measures of performance. This approach helps to provide a lot of information to the management that will assist them in strategic policy formulation and achievement. Balanced scorecard, thus, addresses all areas of performance in an objective and unbiased fashion and gives top management a very fast and comprehensive view of the organisation.
Different Perspectives of Balance Scorecard:
The various perspective’s of Balanced Scorecard that allows the manager to look at the business by seeking to provide answers are discussed below:
(i) The Customer Perspective (How do customers see us?):
In this perspective, managers should identify the customers and the market segment in which the business unit will compete. This perspective typically includes several core or genetic measures that relate to customer loyalty and the result of the strategy in the targeted segment. They include market share, customer retention, new customer acquisition, customer satisfaction and customer profitability.
(ii) The Internal Business Perspective (What must we excel at?):
In the internal business process perspective, managers identify the critical internal processes for which the organisation must excel in implementing its strategy.
The principal internal business processes include the following:
(a) Innovation processes for exploring the needs of the customer.
(b) Operation processes with a view to providing efficient management consistent and timely delivery product/service.
(c) Post service sales processes.
(iii) The learning and Growth Perspective (can we continues to improve and create value?):
It identifies the infrastructure that the business must build to create long term growth and improvement. There will be focus on factors like employee capability, employee productivity, employee satisfaction, employee retention. Under the existing business scenario, company will need an excellent information system.
(iv) The financial perspective (How do we look to the shareholders?):
Under this perspective the focus will be on financial measures like operating profit, ROI, Residual income, economic value added concept, revenue growth, cost reduction, asset utilisation, etc. These financial measures will provide feedback on whether improved operational performance is being translated into improved financial performance.
Evaluation Performance: Technique # 3. Variance Analysis:
Control is very important function of management. Through control management ensures that performance of the organisation conforms to its plans and objectives. Analysis of variances is very helpful in controlling the performance and achieving the profits that have been planned.
The difference between the standard cost of profit or sales and actual cost or profit or sales is known as variance and the process by which the total difference between standard cost or sales and actual cost or sales is broken down into its different parts is known as variance analysis.
When actual cost is less than standard cost or actual profit is better than standard profit, it is known as favourable variance and such a variance is usually a sign of efficiency of the organisation. On the other hand, when actual cost or standard profit or standard sales is more than standard cost or actual profit or sales, it is called un-favourable or adverse variance and is an indicator of inefficiency of the organisation.
The favourable and un-favourable variances are also known as credit and debit variances respectively. Variances of different items of cost provide the key to cost control because they disclose whether and to what extent standard set have been achieved.
Another way of classifying the variances may be controllable and uncontrollable or random variances. When the variance is due to efficiency of a cost centre (i.e., individual or department) it is said to be controllable variance. Such a variance can be corrected by taking a suitable action.
For example, if actual quantity of material used is more than the standard quantity, the foreman concerned would be responsible for it. But if excessive use is due to defective supply of materials or wrong setting of standards, the Purchasing Department or Cost Accounting Department would be responsible for it.
On the other hand, an uncontrollable or random variance does not relate to an individual or department but it arises due to external reasons like increase in prices of materials. This type of variance is not controllable and no particular individual can be held responsible for it.
There are a number of reasons which give rise to variances and the analysis of variances will help to locate the reason and person or department responsible for a particular variance. The management needs not pay attention two items or departments proceedings according to standard laid down.
It is only in case of un-favourable items that they have to exercise control. This type of management technique is known as ‘management by exception’. This type of technique is considered as an efficient way of exercising control because management cannot devote their limited time to every item.
The deviation of total actual cost from total standard cost is known as total cost variance. It is a net variance which is the aggregate of all variances relating to various elements of cost, both favourable and un-favourable.
Analysis of variances may be done in respect of each element of cost and sales viz.:
i. Direct Material Variances,
ii. Direct Labour Variances,
iii. Overhead Variances,
iv. Sales Variances.
Evaluation Performance: Technique # 4. Contribution Margin:
Contribution margin can be defined as the difference between the sales and the variable cost of those sales. It contributes towards fixed expenses and profit. A profit centre or investment centre giving more contribution is preferred because it will give higher figure of profit taking fixed expenses as constant. It is a very good device for optimising the use of scarce resources.
Contribution is different from the profit which is net gain in activity and remains after deducting fixed expenses from the total contribution. Contribution margin is a good technique of performance measurement as it helps to find out the profitability of a product, department or division, to have better product mix, for profit planning and to maximise the profit of a firm.
The main drawback of this technique as a measure of performance is that it does not give due consideration to fixed expenses. With the development of technology, fixed expenses have increased and their impact on production is much more than that of variable expenses.
Therefore, a technique of performance evaluation which ignores fixed expenses is less effective because a significant portion of the cost representing fixed expenses is not taken care of.
Another important limitation of contribution margin approach is that firms in a competition industry might be induced to sell at prices which cover variable costs and give contribution but fail to earn an adequate return on investment in fixed assets. A technique of performance evaluation should lay emphasis on the need for making an adequate return on capital employed in a division or department.
In the technique of contribution margin, time taken for the completion of jobs is not given due attention because marginal cost excludes fixed expenses which are connected with time. Fixed expenses should be considered if the suitable comparison of two jobs is to be made.
A company has two divisions, A and B. The division A is currently operating at full capacity. It has been asked to supply its product to division B. Division A sells its product to its regular customers for Rs.30 each. Division B (currently operating at 50% capacity) is willing to pay Rs.20 each for the component produced by division A (this represents the full absorption cost per component at division A).
The components will be used by division B in supplementing its main product to conform to the need of special order.
As per the contract terms of sales, the buyer calls for reimbursement of full cost to division B plus 10%.
Division A has a variable cost of Rs.17 per component. The cost per unit of division B subsequent to the buying part from division A is estimated as follows:
The company uses contribution margin technique for evaluation of divisional performance. Required
(a) As manager of division A, would you recommend sales of your output to division B at the stipulated price of Rs.20.
(b) Would it be in the overall interest of the company for division A to sell its output to division B?
Computation of Contribution per Unit on Output of Division A if Output is Sold Externally
As manager of division A, sale at t 20 per unit to B, should not be recommended because contribution per unit will reduce from Rs 13 to Rs 10. Division A is already operating at its full capacity and market is absorbing all its output at Rs 30 per unit. The internal transfer made to division B would reduce contribution and profit of division A by Rs 10 per unit.
It will be in the overall interest of the company that the transfer takes place as it would increase the firm’s contribution by Rs.50 per unit.
A company which sells four products, some of them unprofitable propose, discontinuing the sale of one of them.
Following information is available regarding its income, costs and activities for a year:
Its overhead costs and basis of allocation are:
You are required to:
(a) Prepare a profit and loss statement showing percentage profit or loss on sales for each product.
(b) Compare the profit if the company discontinues sales of product B with the profit if it discontinues product C.
Since contribution in case of product B is negative, it is better to discontinue product B only thereby the profit will be maximum. By discontinuing product B, profit will be Rs.79,000 as compared to the existing profit of Rs.65,000.
Evaluation Performance: Technique # 5. Return on Capital Employed (ROCE):
Return on capital employed or return on investment is an indicator of the earning capacity of the capital employed in the business. Return on investment gives an idea of the efficiency or otherwise of an investment centre of the ratio is calculated for a particular investment centre.
Measuring the performance of an investment centre requires a comparison of the profit that has been earned with capital employed in the investment centre.
The alternative method of calculating ratio of ROI gives better idea of the operating efficiency of capital employed as compared to the first way of calculating ROI because it throws light on operating profit margin and assets turnover. The ratio of operating profit to sales is the result of firm’s pricing policy and its cost control.
The ratio will be higher if strict control is exercised on various elements of cost and or higher selling prices are realized by providing quality goods to customers. If profit margin ratio is lower, it will give an idea of increased cost and/or lower selling prices.
Assets turnover or capital turnover ratio shows the amount of sales generated by the assets available or capital employed and gives an idea whether assets are being utilized properly or not. The higher the capital turnover ratio, the better it is for the firm.
ROI is considered to be the most important ratio because it reflects the overall efficiency with which capital is used. This ratio is a helpful tool for making investment decisions. A project yielding higher return on investment is favoured.
ROI can be improved by any of the following factors, all other factors being held constant:
(i) A decrease in operating costs.
(ii) An increase in selling price.
(iii) An increase in sales volume.
(iv) A reduction in amount of capital employed.
In considering the suitability of return on capital employed for measuring performance, operating profit and capital employed should be clearly defined for getting comparable results of operating performance of difficult divisions or years.
Operating Profit = Profit before interest on long term borrowings and tax
Capital Employed = Equity Share Capital + Preference Share Capital + Undistributed
Profit + Reserves and Surplus + Long-term Liabilities − Fictitious.
Assets − Non-business Assets
Alternatively = Tangible Fixed and Intangible Assets + Current Assets − Current
Limitations of ROI:
1. Satisfactory definitions of profit and capital employed may not be available. Profit has many concepts such as profit before interest and tax, profit after interest but before tax, profit after interest and tax, profit before deducting fixed expenses etc.
Similarly, capital employed may be taken as gross capital employed (total of all funds long-term and short-term invested in a firm), net capital employed (only long-term funds invested in a firm), assets including or excluding intangible assets, assets taken at their book value or at their current cost etc.
2. ROI of different firms for making an analysis of their comparable performance may not serve the purpose if they follow different accounting policies and methods in respect of valuation of fixed assets, valuation of stock, apportionment and absorption of overheads etc.
3. ROI may not be suitable for making analysis of short term performances. In the initial years, a new investment may give a very small ROI which may mislead the management and a wrong decision of not making the investment may be taken. It is possible that ROI may improve in course of time when the initial obstacles are overcome.
4. It is quite possible that ROI may influence a divisional manager to select only those investments which give higher rates of return to achieve his target ROI. Other investments that reduce his division’s ROI but could increase the value of the firm may be rejected by the divisional manager.
Mr. T. Munim is made an offer by the promotes of Swargiya Enterprises Ltd. to invest in project of the company by purchasing a substantial portion of the share capital. He is promised good returns by way of dividends and capital appreciation.
Mr. Munim desires that you compute the following ratios for financial analysis. Workings should form part of your answer.
(i) Return on Investment Ratio and
(ii) Net Profit Ratio.
The figures given to him are as under:
Compute the return on investment from the following information relating to a firm:
Division A and B are considering new investment projects. From the information given below, you are required to” suggest whether new investment projects should be undertaken or not.
Division A should accept the new investment as its ROI of 16% is higher than target ROI of 15%. Division B should reject the new investment because ROI of 14% on new investment is lower than target ROI of 15%.
Evaluation Performance: Technique # 6. Residual Income (RI):
The General Electric Company of US developed the Concept of Residual Income (RI) as an alternative to Return on Investment (ROI).
Residual Income (RI) is defined as income remaining out of profit before taxes after making provision for the expected return on investment. The expected return is considered as the capital (imputed interest) charge. The idea is that the division bars a charge for the assets provided by the organisation to the division for use.
RI = Profit − Capital Charge
= Profit − (Required Rate of Return x Investment)
It is used to assess divisional performance.
Here, capital (imputed interest) charge represents interest forgone as a result of funds tied up in the business. In other words, imputed interest is the opportunity cost of the funds invested in the business. Evaluation of the performance of a firm or division of a firm will be made by the size of the residual income.
The objective of a firm should be to maximise its residual income. As long as the firm or the division earns a rate of income in excess of the imputed interest charge for the investments made in the firm or the division, the firm or division should expand.
ROI may induce a divisional manger to select only those investments which give high rates of return that are in line or above his target ROI. Other investments that reduce division’s target ROI but could increase the overall value of the firm may be rejected by the divisional manager.
But it will not be the case if the residual income is made a criterion for evaluating the performance of a divisional manager. Objective of overall increase in the value of the firm is more likely to be achieved by using residual income rather than ROI as a divisional manager’s performance measure.
Advantages of the Residual Income:
i. It maximises the overall value and growth of the firm and increases shareholders’ wealth by accepting investments which give a rate of return in excess of the cost of capital.
ii. Divisional managers become aware of the opportunity cost of funds and they accept those investments which give a higher rate of return than the rate of imputed interest.
iii. It avoids taking sub-optimal decision because investments are not rejected by divisional managers merely because they lower their target ROI.
iv. Goal congruence (overall objective of the firm) is more likely to be achieved by using residual income rather than ROI as a technique of performance evaluation.
Weaknesses (or Limitations) of RI:
i. It is difficult to have satisfactory definition of income and investment.
ii. It may be difficult to get the rate of imputed interest because it depends on factors like risk, demand and supply of capital etc.
iii. Residual income is an absolute measure of performance because it is expressed in rupees. It will not provide a proper basis for evaluation of organisational performance which is affected by the size of the organisation. ROI being a relative measure expressed in percentage is a better technique of organisational performance as compared to the residual income.
According to Horngren, Foster and Datar:
“Both ROI and residual income represent the results for a single time period (such as a year). Managers can take actions that cause short-run increases in ROI or residual income but are in conflict with the long-run interests of the organisation. For example, managers may curtail research and development and plant maintenance in the last three months of a fiscal year to achieve a target level of annual operating income”.
Following information relates a profit centre P1 of a manufacturing company:
The amount of capital employed in profit centre Pi is Rs 75, 00,000 and the cost of capital is 15%. You are required to calculate: (i) ROI and (ii) RI. Give your comments.
Desired rate of return is 15% but profit centre P1 gives ROI 13-33%. Residual income is negative figure of Rs.1, 25,000 because cost of capital of Rs.11, 25,000 is more than profit of Rs.10,00,000. Hence performance of profit centre Pi is not satisfactory at all.
Division Y of C Ltd. has employed Rs.1,00,000 and earned an annual profit (after depreciation) of Rs.18,000. The divisional manager is considering an investment of Rs.10,000 in an asset which will have a ten-year life with no residual value and will earn a constant annual profit (after depreciation) of Rs.1,600. The cost of capital is 15%.
(i) The return on divisional investment and the divisional residual income before and after the new investment, and
(ii) The net present value of the new investment (10-year annuity factor at 15%: 5.019). Also comment on the results.
With the new investment, Division Y’s performance as adjudged by ROI has declined because ROI has decreased to 17.82% from 18%.
On the basis of RI, new investment is justified because residual income has increased from Rs.3,000 to Rs.3,100. Cost of capital of additional investment is Rs.1,500 whereas additional profit is Rs.1,600.
(ii) Statement Showing the Net Present Value of the New Investment:
Apparel division of ALERT LTD. has employed Rs.20 lakhs and earned an annual profit (after depreciation) of Rs. 3,50,000. The Divisional Manager is considering an investment of Rs.80,000 in an asset which will have a eight-year life with no residual value and will earn a constant annual profit after depreciation of Rs.12,800.
The cost of capital is 15 per cent. Ignore taxation.
You are required to work out:
(i) The return on divisional investment and the divisional residual income before and after the new investment.
(ii) The Net Present Value (NPV) of the new investment. (PV factor of an annuity of Rs.1 for 8 years at 15% = 4.4873).
Also comment on the results.
With the new investment it would appear that Apparel division’s performance as adjudged by ROI has declined. This problem arises often with ROI.
RI after new investment will be enhanced to Rs.50,800. Thus, the performance of Apparel division would apparently show an improvement on Residual Income (RI) justifying new investment. The use of RI has highlighted the fact that new project return is more than the cost of capital (16% compared with 15%).
Evaluation Performance: Technique # 7. Value Added:
Value added is the change in market value resulting from an alternation in the form, location or availability of a product or service excluding the cost of bought-in-material and services. It is the excess of sales revenue plus income from services over the cost of bought in goods and services purchased from outsiders.
It can also be defined as the wealth the organisation has created by people working in the business, by providers of capital and by the Government which has a responsibility for the social and economic environment within which the business operates.
In this sense it will be calculated by taking the total of employees’ costs (i.e., wages, salaries and cost of other benefits given to employees), interest on loans, dividend, Government takes, depreciation and retained profits.
Value added differs from the conventional profit depicted by Profit and Loss Account because conventional profit’s calculations deduct all costs from sales and other incomes whereas value added is obtained by deducting the cost of bought-in-material and services from sales and other incomes.
Every effort should be made to increase the value of products produced or services provided by a firm so that these may be more addition to the wealth of the organisation. The figure of value added is more important to measure, evaluate and judge the performance of an enterprise than the figure of profit because it excludes those costs over which the firm has either no control or at best a little control.
An organisation may survive without earning profit but cannot survive without adding value. Any business which is not making profit shall become risk but any business not generating value would be an evil and not desirable at all form the society’s point of view.
Evaluation Performance: Technique # 8. Bench Marking:
The increased global competition calls for special competence of increased cost efficiency for a company for its very survival. Bench marking is a technique which will help a company to achieve this comparative cost efficiency.
Bench marking may be defined as a continuous information sharing process, adopted by an organisation internally and externally to identify its strong or weak points against the toughest competitors, to improve the activities carried out and services provided by it. Companies choose to bench mark excellent companies whose business process is similar to their own.
A bench mark amount is the best level of performance that can be found inside or outside the organisation.
The bench mark exercise has six essential steps as given below:
(i) Identifying key variables for bench marking
(ii) Selecting comparative companies (i.e., excellent companies)
(iii) Gathering required data
(iv) Increased budget for idea generation and training
(v) Evaluating and interpreting the performance gap
(vi) Improving the performance to achieve world class operations.
Bench marking is to be treated as a continuous learning process and it should result in innovations. In order to effectively bench mark, it is vital to determine the real difference between our firm and business process leader to be copied or imitated and comparison must be made in at least in the following essential areas:
(i) Cost of product/service
(iii) Standard of performance achieved
Pro-active bench marking is the need of the hour which will monitor that the input costs do not blunt the competitive edge thereby makes a company fit to be a global player, to beat the best competitor in the world.
David T. Kearns, the former chief executive of Xerox, has rightly defined bench marking as follows:
“Bench marking is the continuous process of measuring products, services and business practices through the comparison with the strongest competitors or with companies that are recognised as industry leaders.” It is a continuous search for superior competitive performance.
Advantages of Bench Marking:
i. Bench marking is a continuous search for better ways to make improvement in the performance of the organisation. This results in better processes of production and managing business and leads to higher profits.
ii. It helps in reduction of cost and improvement of quality of the products.
iii. It leads to higher customer satisfaction levels because efforts are made to follow the practices of business leaders.
Evaluation Performance: Technique # 9. Ratio Analysis:
Ratio analysis is an important analytical for measuring performance of a firm. Ratio is the numerical or an arithmetical relationship between two figures. It is expressed when one figure is divided by another. Absolute figures are valuable but they standing alone convey no meaning unless compared with another. Various types of ratios are calculated for evaluating the performance of a firm.
Evaluation Performance: Technique # 10. Non-Financial Quality Performance Measures:
Profitability alone is inadequate to measure the performance of various centres. There is no denying the fact that financial measures are important measures for evaluating the performance of cost centres, profit centres and investment centres. But these measures are not fully adequate measures for performance evaluation.
Further these measures are short-term measures. Divisional managers, to achieve their short-term targets, may be induced to derive short-term benefits by using these techniques at the expense of long-term benefit of the firm. Therefore, it is desirable-to use non-financial measures for evaluating the performance besides using financial measures.
Following non-financial measures should also be considered along with financial measures for evaluation of the performance:
(i) Market Share for each major product
(ii) Product leadership.
(iii) Product or service quality.
(iv) Delivery reliability.
(vi) Personnel turnover popularly known as labour turnover.
(vii) Personnel development.
(viii) Personnel satisfaction.
(ix) Customers’ after sale service.
(x) Customer satisfaction (ultimate measure of quality).
(xi) Employment opportunities.
(xii) Minimisation of wastages and losses.
(xiii) Social responsibilities etc.
Non-financial measures are very important for the overall success of a firm. Financial measures alone may not measure the overall performance of a firm. To quote Dr. Jawahar Lal, “It is slightly claimed that any financial measures like ROI and RI have drawbacks while evaluating divisional performance, since it is virtually impossible to capture in one financial measure all the variables that measure the success of a division”.
For example, two divisional managers having equal amounts of investments in their respective divisions may also have some rate of return on investment. However, this does not mean that their performances are also equal.
It is possible that one division might have provided excellent after sale service and thereby has enhanced the reputation of the firm. On the other hand the other division might not have taken any care of after sale service.
Earlier, little attention was given to non-financial performance measures when there was sellers’ market. But now-a-days when there is acute competition and there is wide choice for buyers, it is desirable to give due attention to non-financial measures for evaluating the performance of managers so that they may become aware of providing facilities to customers to have a hold on the market.
From the above discussion of all performance measures it is clear that an effective performance evaluation system should emphasise both financial and non-financial measures.